By the Bitcoin Legal Team – Martin Mushkin, Joseph Sahid, Joseph Taub, and Rony GuldmannOriginally published in the July 2015 issue pf yBitcoin Magazine. Reprinted here with permission of the publisher.

Congratulations, virtual currency world—New York is regulating you! Some of you may have to apply for a NY Bitlicense. California may soon follow. That’s how important Bitcoin and other digital currencies have become in recent years. And as we know, what happens in New York’s financial world often has implications for the wider world. All the recent attention New York, California and even North Carolina have paid to virtual currency (more on that below), is raising many important legal questions, with potentially profound implications. But first, let’s explore the basics.

A Cryptic History of Money

Bitcoin is the latest and best known in a long line of digital currencies. The basic premise of digital currencies is that they try to establish a medium of exchange based on immutable mathematics, putting the currency beyond the control or manipulation of any government. Not long after the computer was invented people started discussing the development of currency based on that series of zeroes and ones called “bits.”

But mediums of exchange go back to the first bartering by cave people. When A and B first exchanged goods, each was getting something from the other that he wanted. Soon, there came a point when B didn’t really want more apples but knew that he could exchange them with C for the tomatoes B really wanted. Shortly thereafter he had an inventory waiting to be bartered. And soon after that, B needed some means of storing his accumulating wealth other than in the tomatoes and other produce he had bartered for.

Initially, B’s accumulated wealth might have been represented in certain beads or special rocks. Next came smelted copper and eventually gold and silver. Then there was the problem of storage for this wealth inventory. So here came banks and coins minted by governments, followed by the age of paper or fiat money, checks and credit cards. Today, instead of masses of paper moving through the banking system, all this transfer of wealth—debiting and crediting—takes place electronically. That means we are already in the digital currency era.

A Few Legal Questions

“What is needed is an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party. Transactions that are computationally impractical to reverse would protect sellers from fraud…. The system is secure as long as honest nodes collectively control more CPU power than any cooperating group of attacker nodes.”

What Nakamoto could not address at the time was Bitcoin’s legal status in the currency and taxation worlds. What exactly is Bitcoin for legal purposes? This is a critical question, because Bitcoin’s legal characterization determines whether it is regulated, how it is regulated and who regulates it.

Thus far, Bitcoin has been regarded as both a currency and a commodity. A federal court in Texas held that since Bitcoin could be used to buy things other than Bitcoin itself, it was money. The court found that paying in bitcoins for shares in a business run by others for profit was buying a security and subject to SEC regulation. The court did not concern itself with what the business planned to do with the “money.” The court could have classified the transaction as an investment in commodities, as a Bitcoin trading business or as trading in FOREX (foreign exchange). The case presented different ways of looking at Bitcoin, along with several possible regulatory schemes: currency, securities, commodities and FOREX. Incidentally, the Texas business said it intended to deal in Bitcoin, but it turned out to be a Ponzi scheme.

All of this suggests another question: Who has legal jurisdiction over Bitcoin transactions? Suppose Company A, physically in country X, uses the Internet to find an exchange, GiveandTake, upon which it can offer its shares. It only accepts payment in Bitcoin. The exchange is only virtual and Company A does not know where the exchange is located. Company A offers its securities, and investors pay for it by depositing bitcoins into Company A’s electronic wallet. The wallet is administered by Maybesafe, thought to be in country Y. Company A does not have the physical name and address of Maybesafe or the investors. All it has is email addresses. Of course, the securities the investors purchase are really electronic entries. Later, Company A pays dividends to the investors by sending the dividends to their virtual wallets via their email addresses. These recipients could be anywhere in the world.

Suppose things go wrong. Perhaps some of Nakamoto’s “honest nodes” succumb to “attacker nodes.” Maybe the business simply goes bankrupt. What government(s) can take jurisdiction? To what court can the injured party go to seek justice: where the physical offices of the various participants are located, or the location of their servers?

The New York Story

New York State, Wall Street’s home, has promulgated regulations defining its jurisdiction as covering any transaction “involving New York or any resident of New York.” There are stated limits to “involving.” Chips or the like used on gaming platforms, gift cards, and credits that can only be used with a designated merchant or set of merchants are exempt so long as they cannot be converted to fiat money. However, “involving” is so broad that anybody whose Bitcoin transactions are even tangentially related to New York will have to carefully consider whether they are legally obligated to get a New York license.

The only meaningful exclusions are for “merchants and consumers” who “utilize Virtual Currency solely for the purchase or sale of goods or services,” software developers and those using Virtual Currency solely for investment purposes. The regulation does not expressly cover miners unless they are deemed to be “issuers,” who must be licensed.

In the banking world, New York’s highest court ruled that its courts had jurisdiction over Lebanese Canadian Bank when it was sued by U.S., Canadian and Israeli citizens resident in Israel who were victims of Hezbollah rocket attacks. The claim was that the bank assisted Hezbollah by “facilitating international money transactions” using its New York correspondent bank to transfer money to Hezbollah agents. This approach could be applied to Bitcoin. Beware Bitcoiners!

In our hypothetical case, New York’s regulations could require that Company A know the physical address of the exchange, that the exchange and wallet be licensed, and that all parties know with whom they are dealing beyond mere email addresses. However, the word “reasonable” appears so often that the regulations do not look like absolutes. Only legal interpretations over time will settle this.

New York’s regulation is not for the faint of heart. It costs $5,000 just to apply. Applicants must submit fingerprints and pictures of employees having access to customer funds, extensive personnel background information, certification of an outside investigator, a detailed business plan and audited financials—much like a bank. Once in business, a licensee must have a written compliance plan, maintain compliance personnel, be audited and report frequently to the regulators. For example, if $10,000 in Bitcoin or money is transmitted in “one day by one person,” in a transaction “involving New York or any resident of New York,” the licensees will have to report the transaction to the New York regulators within 24 hours. Importantly, the regulators can grant conditional licenses under limited circumstances.

The regulation requires all advertisements by Bitlicensees to include their names and a statement that they are licensed to engage in “Virtual Currency Business” by New York. The Bitlicense will serve as an advertised badge of integrity, like a bank saying it is a member of the FDIC. Hopefully, there will be no Mt. Gox or Silk Road fiascos by New York Bitlicensees. Will a New York badge of integrity be worth it?

A bill before the California legislature would regulate Bitcoiners similarly. We predict that some variant of these regulations will pass in California.

Federal Laws Also Apply

The Treasury’s Federal Crime Enforcement Network (FinCEN) requires U.S. financial institutions to assist U.S. government agencies to detect and prevent money laundering and other criminal activity. Under the Electronic Funds Transfer Act, any transfer of funds, other than a transaction originated by check or similar paper instrument, which is initiated through an electronic terminal, telephonic instrument or computer, must be reported. “Money transmitting” includes transferring funds on behalf of the public by any and all means within this country or abroad. These laws ostensibly cover Bitcoin transactions–honest transactions as well as the illegal drug dealings in the infamous Silk Road case. FinCEN has opined that certain Bitcoiners are “money transmitters.”

Bitcoiners, like all businesses, will have to comply with the securities laws, privacy, tax, health and social security laws, and honor their contracts (or risk being sued). For Bitcoiners, regulation will greatly compromise the vaunted anonymity of the currency. This is a matter of more than a little concern to many in the Bitcoin community.

And About the Rest of the World…

New York isn’t the only jurisdiction with an interest in regulating Bitcoin, but with New York being the 800-pound gorilla of the financial world that it is, you can bet that the rest of the world is watching very closely. Given Bitcoin’s endurance and ever-evolving prominence on the world’s financial stage, governments everywhere are considering regulation, and they will most certainly be closely observing what happens in New York.

As it stands now, Russia and others may criminalize Bitcoin in the future. Russia continues to dither on Bitcoin. On the other hand Russia and others may find that criminalization is unsustainable and a bad move for their own financial systems. The best advice from here is to stay tuned. Bitcoin remains an ever-evolving legal quandary.

Bitcoin Snapshot: Ecuador and Russia

Ecuador has banned Bitcoin while preparing to institute the world’s first state-run digital currency, which will be running parallel to the U.S. dollar, upon which the country has relied since its banking crisis in 2000. This currency will not strictly speaking be a virtual currency, because every unit of it will have to be backed up with dollars. Nevertheless, it is intended to provide many of the same benefits that have been associated with Bitcoin, such as allowing people like the rural poor, who do not have access to traditional banking, to conduct transactions through their cell phones.

The situation in Russia has been shifting and ambiguous since the beginning of 2014. In January 2014, the Bank of Russia issued a statement discouraging the use of bitcoins, warning that Russians who use them risk becoming unwittingly involved in illegal activities. After a meeting with the Bank of Russia, Russia’s Prosecutor General announced in February 2014 that with the ruble being the official currency of the Russian Federation, existing Russian law categorically prohibits Bitcoin. The Bank of Russia, however, came away with a different interpretation of that meeting and in March 2014 clarified that it had not concluded that all cryptocurrencies were prohibited and that the meeting was merely intended to develop a regulatory framework to combat illegal operations and protect the rights of users.

It seems that the matter will be settled soon enough, though, as Russia’s Finance Ministry is now backing a bill that would fine individuals involved with virtual currencies the equivalent of between $100 and $840, according to the nature of the offense. Officials and legal entities would face substantially higher fines, up to $12,500. While the Finance Ministry has backed off its earlier attempts to impose more severe fines, its underlying hostility to virtual currencies remains intact. Its position is, however, opposed by the chair of the Duma’s Committee on Financial Markets. Some other players in the Duma, however, are demanding that the law include draconian fines, and Russia’s equivalent of the FCC has banned several Bitcoin-related websites. On the other hand, the country’s Ministry of Economic Development has pushed back against the Finance Ministry’s draft law, arguing that it lacks precision and would prohibit non-cash payment systems like bonus points and gift certificates. Whether the Ministry of Economic Development’s resistance to the present draft of the law indicates any new sympathy for Bitcoin itself remains unclear, though. Given Russia’s well-documented ambivalence on the matter, the bill’s exact fate remains uncertain as a vote looms later this year. On a brighter note, Russian courts have recently declared illegal the government’s attempts to ban several Bitcoin-related websites, indicating that on matters not of major political importance Russia can be a nation of laws.

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